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What Can Happen with Gold If the Dollar Collapses?

By: Przemyslaw Radomski | Tuesday, December 4, 2012

Today's essay is the first one in our two-part commentary on U.S. debt and
the dollar collapse.

On numerous occasions we have gone back in our commentaries to the year 1971
and U.S. President Richard Nixon's decision to cut off the ties between the
greenback and gold. Today, we revisit the topic once more and check what kind
of implications it has for the price of the yellow metal.

Prior to 1971 the most prominent world currencies had been regulated by the Bretton
Woods system. Under this agreement, the U.S. agreed to link the dollar
to gold. This meant that any amount of dollars handed over by a foreign government
or central bank would be exchanged for gold at $35 per ounce. Such an arrangement
had a particularly important consequence for money creation. Namely, the
U.S. government shouldn't issue more paper money than it had physical gold
to back this money up. In practice, it was rather improbable that all the
dollars would have to be exchanged for gold at once, so the U.S. government
in fact issued more money than it could have paid for with gold, but the
main restriction was in place: debt numbers couldn't be inflated to unsustainable
levels.

In 1944 when the Bretton Woods system was introduced, the relation of U.S.
debt to the official Treasury gold reserves stood at $319.90 per ounce of gold.
This meant that there was $319.90 of borrowed money for every ounce of gold
the U.S. had. With the price of gold at $35, a quick calculation shows that
the U.S. gold reserves could have paid for about 10.9% of its debt. At first,
it might seem that there was a lot of debt compared to gold assets. On the
other hand, however, such a ratio was similar to reserves required from commercial
banks by the regulator. In a way, the U.S. operated like a bank (with a lot
of differences, of course).

By 1970, partly due to the Vietnam War, the U.S. began running consistent
deficits. The government printed more dollars to meet its obligations and the
amount of debt per ounce of gold surged to $1,172.56. The coverage of debt
in gold went down to 3.1%. The ability of the U.S. to keep up to the promise
to exchange dollars for gold was put into question. Nixon, fearing a situation
in which foreign central banks would make a collective bank run on Fort Knox,
decided to cease to exchange the dollar for gold and directly break the Bretton
Woods agreement.

From that moment on, the dollar has been a fiat currency, that is a
currency not backed by a physical asset, just by a promise of the government
to accept payments (taxes) in it. But, as we've just seen, promises can be
broken and right now the ability of the U.S. to pay its debts off in the future
is also being put into question. To see why, take a look at the chart below.

Since 1970 U.S. debt has gone up from $370.9 bln to $16,159.5 bln, which is
a more than 41-fold increase (!). Since 2000 gold has appreciated along with
the ever sharper increase in debt. A similar chart was discussed in our commentary
on gold
as insurance.

Our next chart shows the rates of change (ROC) of both the U.S. debt and the
average annual price of gold between 1920 and 2012.

The annual ROC of U.S. debt was in a general downtrend in the 1983-2000 period
which was accompanied by poor performance of gold. Since 2000, the ROC of U.S.
debt has been increasing again, which means that debt has been growing increasingly
rapidly. This coincided with gold's extraordinary performance during the last
10 years.

The U.S. Federal Reserve, led by Ben Bernanke, initiated three substantial
rounds of what it calls quantitative easing (QE). In short, QE is a
process in which the Fed buys government bonds and other assets from secondary
markets with newly created dollars. Its (official) purpose is not to finance
government deficits but rather to bring the U.S. economy back on the growth
trajectory. Nonetheless, the effects of QE can be compared to those of printing
enormous amounts of money. Just to give you an idea of how much debt the consecutive
rounds of QE have so far created (approximate amounts):

QE1 (Nov 2008 - Mar 2010): $1.65 trillion

QE2 (Nov 2010 - Jun 2011): $600 billion

QE3 (Sep 2012 - ?): $40 billion per month.

As a matter of fact, Fed's quest to provide the economy with more incentives
has not stopped. The direct effect of QE on debt is reflected on the chart
below.

In the period between January 2012 and November 2012 U.S. debt grew by 7.2%.
There's more to it: QE3 is an open-ended operation. This means that there is
no limit on the amount of money the Fed can create and inflate the debt with
within QE3. The purchases in the amount of $40 billion per month will continue
as long as the Fed deems necessary.

The points mentioned above add up to a picture which is not at all rosy for
the U.S. But it's not apocalyptic either. Particularly for precious metals
investors. Let us explain why.

It belongs to common sense that you can't borrow money forever. Economics
has a lot of intricacies and can be quite complicated at times but the basic
rules are very simple. You borrow, you have to pay back. So if the government
borrows too much and can't pay it back, it will have to go bankrupt. The more
debt it has, the worse its reputation is. People are less willing to put their
money into treasury bills of a government with excessive debt. If the economy
is shaky and the government is printing money, it damages its reputation but
also makes the currency worth less and less. Hyperinflation is not a default
nor bankruptcy in technical terms, but it is in practical terms. For the USD
bond holders it will make little difference if they are not paid or paid something
that is worthless.

In such an environment investors, motivated psychologically, turn to gold
and silver. As Warren Buffet correctly pointed out:

"[Gold] gets dug out of the ground in Africa, or someplace. Then we melt
it down, dig another hole, bury it again and pay people to stand around
guarding it. It has no utility. Anyone watching from Mars would be scratching
their head."

But there's one side of precious metals that is not covered by that quote.
Gold and silver may be just lumps of metal but what makes them extremely interesting
is the psychological association people have with them. Gold and silver
have been used as currencies throughout the centuries. And people, for
whatever reason, perceive them as valuable, particularly in times of economic
turbulence. This alone stipulates that gold and silver prices may rise along
with the worsening of the economic situation. And in case of the unlikely collapse
of paper currencies, gold and silver could quite naturally come in as the base
of a new monetary system.

The possibility we would like to highlight now is the default of the U.S.
on its obligations and the demise of the dollar. In this scenario, a new currency
system based on the gold standard is introduced. The financial collapse is
usually perceived as Armageddon but doesn't necessarily have to be one. Just
imagine, even in case of the U.S. government defaulting on its obligations,
the assets that the country has would remain in place. The buildings, cars
and infrastructure would still be there, they wouldn't melt down in the possible
financial crisis.

A lot of property would change hands and there definitely would be turmoil,
but it wouldn't need to amount to a civil war. Take a look at Latvia, a country
where the GDP between 2007 and 2009 shrank by 24%, where unemployment shot
up to 30% in 2010. Where the government laid off 30% of the civil servants
and cut payrolls by 40%. Latvia didn't disintegrate.

So what implications for gold would a collapse of the U.S. dollar have? The
next chart will aid us to analyze such an occurrence.

This chart presents the already mentioned relation of U.S. debt to Treasury
gold reserves - the amount of debt per one ounce of gold - up to 2012. The
red line represents U.S. Treasury gold reserves in metric tonnes, while the
yellow line denotes the amount of U.S. debt in dollars per ounce of gold. The
debt per ounce has visibly increased since 1971, accelerating around 2000 and
even more around 2008. In 2012, there were $61,796.11 of debt per one ounce
of gold owned by the U.S. government.

Now, if a new gold standard is introduced and the agreement works like the
Bretton Woods system, the dollar (or whatever other currency) would be tied
to gold. As noted earlier in this essay, at the introduction of the Bretton
Woods agreement in 1944 the debt coverage for the U.S. stood at 10.9% (or $319.90
of debt per one troy ounce of gold). If the new system were based on similar
assumptions with debt coverage at 10%, this would imply a fixed price of $6,179.61
per ounce of gold ($6,179.61 per ounce of gold divided by $61,796.11 of
debt per one ounce of gold gives us coverage of 10%).

But is the dollar collapse all that likely? Or let us restate the question:
if the dollar doesn't collapse, does it still make sense to be invested in
gold and silver? Bear with us until next week when we publish the second part
of this commentary. Until then you can gain some more insight into why holding
on to precious metals might keep you on the safe side by reading our essays
on gold
and silver as insurance and on gold
and silver portfolio structure.

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Przemyslaw Radomski, CFA (PR) is a precious metals investor and analyst who
takes advantage of the emotionality on the markets, and invites you to do
the same.

His company, Sunshine Profits, publishes analytical software that anyone can
use in order to get an accurate and unbiased view on the current situation.

Recognizing that predicting market behavior with 100% accuracy is a problem
that may never be solved, PR has changed the world of trading and investing
by enabling individuals to get easy access to the level of analysis that
was once available only to institutions.

High quality and profitability of analytical tools available at www.SunshineProfits.com are
results of time, thorough research and testing on PR's own capital.

PR believes that the greatest potential is currently in the precious metals
sector. For that reason it is his main point of interest to help you make
the most of that potential.

As a CFA charterholder, Przemyslaw Radomski shares the highest standards for
professional excellence and ethics for the ultimate benefit of society.

Disclaimer: All essays, research and information found above represent
analyses and opinions of Przemyslaw Radomski, CFA and Sunshine Profits' associates
only. As such, it may prove wrong and be a subject to change without notice.
Opinions and analyses were based on data available to authors of respective
essays at the time of writing. Although the information provided above is
based on careful research and sources that are believed to be accurate, Przemyslaw
Radomski, CFA and his associates do not guarantee the accuracy or thoroughness
of the data or information reported. The opinions published above are neither
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is not a Registered Securities Advisor. By reading Przemyslaw Radomski's,
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for any decisions you make regarding any information provided in these reports.
Investing, trading and speculation in any financial markets may involve high
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as well as members of their families may have a short or long position in
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and may make additional purchases and/or sales of those securities without
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